Reuters Money

Charles Schwab has long been a leader in low-cost retail investing. Now, it’s gearing up for a run at the 401(k) market by hitching its wagon to two ideas whose time may have come: low-cost passive investing and investment advice for plan participants.

Schwab has never been a major player in administering 401(k) plans for employers. The market is dominated by companies like Fidelity Investments, Vanguard and Aon Hewitt. But Schwab is preparing to roll out a new platform for 401(k) plans that it hopes will help it to crack the code.

The idea is to slash investment costs through exclusive use of passive investment vehicles – index funds and Exchange-Traded Funds (ETFs). Then, Schwab intends to plow some of the savings into investment advice for workplace retirement savers that would be built into the platform.

“In the old days of defined benefit pension plans, the outcome was managed for you by professionals,” says Jim McCool, executive vice president of institutional services at Schwab. “But in 401(k) plans, only about one out of 10 investors is getting professional help with investment decisions. We want nine out of 10 to get the benefit of a managed outcome, and take significant expense out at the same time.”

“Our conviction is that the two most incontrovertible features this industry needs to get its hands around are certainty of expense and the impact of advice,” he adds. “Putting those two together is a powerful combination.”

It’s not at all clear that Schwab can make a dent in the business, considering its lack of a track record in the 401(k) market. “Schwab was late to game, and they’ve had very little success cracking large company plans,” says Mike Alfred, CEO of Brightscope, which tracks 401(k) plan performance. “They have nothing to lose by trying this. Companies like Fidelity have a cash cow to protect with their 401(k) record-keeping businesses, and actively managed funds.”

Schwab intends to roll out the new platform in two phases. The first, targeted for launch in the first quarter next year, will be an offering of indexed mutual funds combined with managed accounts; later in the year, Schwab intends to launch a second offering combining advice with ETFs.

Schwab hasn’t released any details thus far on the fund choices to be included, except to say they will be a short list of ultra-low cost passive vehicles, with all major asset classes represented. Schwab also hasn’t named an investment advisory partner yet, although some news accounts have mentioned two companies already focused on advisory services for 401(k) participants – Financial Engines and Guided Choice.

What McCool does say is that Schwab’s 401(k) offering will cost investors no more than 60 basis points on managed assets, “all in.” That would be significantly lower than average.

Brightscope data shows that average 401(k) total plan cost can range from as little as 0.20 percent of assets for the largest plans up to a whopping five percent for smaller plans. And a key driver of cost is proprietary actively-managed funds on the platforms of the big 401(k) platform providers.

Expense is a key determinant of results. A Morningstar study released last year found that fees trumped even the investment firm’s vaunted star rating system as a predictor of success; low-cost funds reviewed by Morningstar had much better returns than high cost funds across every asset class from 2005 through March 2010.

Morningstar found that domestic equity funds with the lowest cost in 2005 returned an annualized 3.35 percent over the time period studied, compared with 2.02 percent for the most expensive group. Likewise, a 2006 report to Congress by the U.S. Government Accountability Office (GAO) found that a one-percentage point increase in fees reduced return over a 20-year period on a typical portfolio by 17 percent.

Schwab’s focus on advisory services is as significant as its intent to slash plan expenses. There isn’t much doubt that 401(k) investors need help. And a changing regulatory scene also could open up some new opportunities in the 401(k) landscape. The U.S. Department of Labor is preparing to adopt new rules that will make it difficult for 401(k) platform providers to sidestep fiduciary responsibility for their offerings – a legal definition that requires an advisor to put the best interest of a client ahead of all else.

That is setting the stage for more big platform companies to add Registered Investment Advisors (RIAs) –who are fiduciaries – to their teams in order to protect marketshare.

For example, Reuters reported recently that Merrill Lynch plans to make at least some of its brokers fiduciaries:

Merrill’s shift reflects the likelihood that the U.S. Department of Labor will adopt a proposal making it harder for advisers to escape assuming a fiduciary standard. If that occurs, advisers fear losing accounts to independent advisers willing to assume the higher standard of care.

“We are actively exploring ways to enter the 401(k) investment consulting market as fiduciaries,” said Andrew Sieg, head of retirement services for Merrill Lynch. He declined to elaborate.

The industry appears to be worried that small RIA firms will team up with open architecture 401(k) platform providers, such as Lincoln Trust and Aspire Financial Services to create cost-effective plans guided by RIAs. It could also include Schwab, which says it intends to market its new 401(k) platform through its existing advisor network.

That could be especially interesting for smaller plans, which often are saddled with higher-cost, lower-performing plans.